Run to Stocks, Not Away from Them

Bernie Schaeffer, editor of the Option Advisor, says sentiment is going all the wrong way—towards bonds and out of stocks—just when the price action for equities is beginning to improve.

Clearly, investors are abandoning the US stock market at an accelerating rate, with the outflow from US stock funds in September 2010 alone equal to about 60% of the total outflow for the full year 2009. And the surge in taxable bond fund flows in 2009-2010 continues apace.

So how do the bearish and bullish stances, respectively, of investors in US stock funds and taxable bond funds stack up against the price action in these asset classes?

As a proxy for the performance of US stocks funds, I’ll use the Standard & Poor’s 500 Index and the Russell 2000; for taxable bond funds, I’ll use the top-performing and popular ($6.25 billion in assets) PIMCO Investment Grade Corporate Bond fund (PBDAX).

Three major points strike me from the [data]:

Over [three months; the year to date; and one, three, five, and ten years,] taxable bond fund returns were comparable to US stock returns, particularly for smaller-cap stocks.

The five-year return figures make a very compelling case for taxable bond funds, and it is clearly the weak period from the 2007 stock market top to the 2009 bottom that is still motivating investor fund flow behavior. Yet, more recent stock market returns do not justify the acceleration in US stock fund outflows.

Smaller-cap [stocks have] been much more lucrative for investors than the large-cap focused S&P, over every period.
So, how does the sentiment, as reflected in the fund flows, play itself out as an indicator of the future performance for these asset classes?

In the case of taxable bond funds, we have massive fund inflows combined with very strong portfolio returns. While it is tempting to [view this as] indicative of a “bond bubble,” no one knows how long these inflows, or the strong price action, will continue. All you can conclude is that these flows are not illogical based on the price action, and that if you are joining this game now, you are not in the early innings.

The picture is significantly different for US stock funds: Investors are accelerating their exit even as the price action improves. It is not a stretch to call this behavior irrational and fear-driven, with the fear based on residual memories of a nasty period in the market that ended 18 months ago, perhaps with an added touch of a hangover from the recent “flash crash.”

Lingering fears related to the 1987 stock market crash kept numerous investors from participating in the powerful bull market of the 1990s. So, I feel there is a strong case for the contrarian call on this negative investor sentiment on US stocks. And an added bonus is the boost a rising stock market would receive should these fund flows ultimately reverse from negative to positive.

As Humphrey Neill said in his classic work The Art of Contrary Thinking, “The crowd is most enthusiastic when it should be cautious and prudent, and most fearful when it should be bold.”